Unifying laws on private investment funds

It is important to note that the Measures are a low level legislation promulgated by the CSRC, which is a department under the State Council. They are intended to temporarily fill the gap before the State Council itself finally adopts a private fund regulation. We anticipate that the Measures will be overridden by this regulation once it comes into force. The CSRC prepared a draft of the Tentative Regulations for the Administration of Private Investment Funds (私募投资基金管理暂行条例) (Regulations) under the direction of the State Council and submitted it for internal review earlier this year. The State Council is reviewing the draft but it is uncertain when it will become law. There appears to be little doubt that the majority, if not all, of the articles contained in the Measures will be incorporated into the Regulations, based on the pattern of legislation by the State Council and its departments. It is therefore worth studying and analysing the Measures.

A casual observer may jump to the conclusion that the Measures have established a uniform private fund regulatory regime under the CSRC's supervision, due to the seemingly universal style of legislation which transcends segregation among the agencies. While it is true that virtually all legal principles set forth in the Measures could potentially be applicable to all types of private funds, Article 2.4 of the Measures unequivocally stipulates that the Measures are only applicable to securities companies, fund management companies, futures companies and their subsidiaries. This means that the Measures are still intended to be binding only for private fund businesses conducted by entities under the CSRC's direct supervision. The regulator's self-restraint is understandable, given the transitional role that the Measures were designed to play. In the Regulations, however, there is no such language; in fact, the Regulations give the CSRC more power and authorisation to regulate and supervise private fund businesses and to implement the Regulations. It can thus be assumed that a uniform private fund regulatory regime will not exist until the State Council's promulgation of the Regulations.

However, it does not naturally follow that all traditional regulatory agencies in the private fund industry other than the CSRC will be out of the picture. After the Measures' effect but before the advent of the uniform regime, the trifurcated regulatory systems will continue to operate in the same way as they used to. Even after the uniform regime's establishment, the NDRC and CBRC will most likely retain some power, although less compared with what they now have. Their residual power may only relate to fund managers and custodial agencies and may no longer touch upon the private funds themselves. Although it is clear that the CSRC is taking the lead in preparing for the forthcoming uniform regime, it remains to be seen how the different regulatory agencies will interact with each other under the new regime.

Understanding the new rules

Those familiar with the US private funds market will not be surprised by the Measures because they, to a large extent, conform to the legal principles and rules commonly seen in the US. Nonetheless, the Measures also reflect the deliberations of the Chinese regulators, which lead to the differences between the two legal systems. Grasping the following key features of the Measures is key to accurately understand the unique aspects of the new law.

Registration and filing

The Measures require each and every private fund manager to register with the Asset Management Association of China (AMAC) and to make a filing with AMAC for the private fund that it manages once the fund has been raised. These are by no means new requirements as the Measures for the Registration of Private Investment Fund Managers and Record Filing of the Funds (Trial Implementation) (私募投资基金管理人登记和基金备案办法(试行)) (Registration and Filing Measures) promulgated by AMAC and effective on February 7 2014 already provide for similar requirements. The Measures do, however, supplement the Registration and Filing Measures in certain aspects (e.g. Article 10). The Measures and the Registration and Filing Measures must therefore be read together to ensure full compliance.

Qualified investor standard

The Measures require that interest in private funds must only be offered to qualified investors and in Article 12 introduce a quantitative standard for determining qualified investors. However, certain entities and individuals such as social security funds and pension funds are deemed to be qualified investors and therefore are not subject to this standard. The statutory definition of qualified investors and the exemptions have set a relatively low threshold for becoming an investor in a private fund. This emphasises the legislator's intention to promote the development of the private fund industry.

Limit on number of investors

The Measures have set the maximum number of investors that a private fund may have. The actual limit varies depending upon the type of fund. For instance, the maximum number of investors of a private securities investment fund is 200, while for a private fund in the legal form of a limited liability partnership (LLP) or limited liability company (LLC), it is no more than 50.

Theoretically speaking, this limit could easily be circumvented by using a multiple-tier fund structure (fund of funds structure) in which each upper-level investor may have qualified investors less than the statutory limit, but, when aggregated, the number of all direct and indirect investors of the lower-level private fund entity could exceed the limit. This potential loophole was directly addressed in the Measures. Article 13 provides that a look-through test will be applied to determine whether the limit on the number of investors has been complied with. For instance, if a private fund in the form of an LLP has a potential limited partner (LP) who itself is also an LLP or a trust, the effect of the test is to look through the LP to reach the ultimate beneficial owners of the interests in the LP. Then it will be determined whether the owners meet the qualified investor requirements, and, if so, they will be integrated with other qualified investors of the private fund when calculating the total number of qualified investors.

Meanwhile, the Measures also provide for certain exemptions from the look-through and integration requirements. According to the last sentence of Article 13, public welfare funds, including social security funds, pension funds and charity funds, are exempted from the look-through test and not subject to integration. More importantly, private funds that are filed with AMAC are also exempted (filed funds exemption). These allow for the fund of funds structure. The most meaningful safe harbour that will most commonly be utilised by general partners (GPs) and fund managers to circumvent the limit on the number of investors is the filed funds exemption, since complying with this requirement imposes no additional burden on GPs/fund managers as all private funds must be filed with AMAC pursuant to Article 8 of the Measures as well as the Registration and Filing Measures in the first place. By relying upon the filed funds exemption, the so-called fund of funds structure could be used where necessary.

There are two important points which may be easily neglected when calculating the number of qualified investors so as to not exceed the limit:

• First, the threshold for becoming a qualified investor for purposes of calculating the number is very low. Ownership of any nominal share of the interest of a private fund would result in the owner being calculated towards the statutory limit, provided that the owner satisfies the standard stated above. By contrast, generally speaking, only the ownership of 10% or more of the voting securities of a private fund would trigger the application of its statutory limit in the US (i.e. the 100-person limit under Section 3(c)(1) of the Investment Company Act).
• Second, fund managers and their employees are deemed qualified investors when they invest in the funds that they manage. They (and their employees) need to be counted when determining the statutory limit. This approach is different from the one adopted in the US where the so-called knowledgeable employee exemption allows for the exclusion of the principals and certain employees of a GP and fund manager when calculating the number of beneficial owners of a specific fund.

Private offering rules

Article 14 defines the private nature of private funds by prohibiting the offering of fund interests through media or otherwise to the general public. Essentially, the Measures prohibit all forms of general solicitation and advertising of fund interests by fund managers and sales agencies. GPs/fund managers have to walk a fine line to ensure that their offering is not classified as illegal fund-raising. While failure to follow private offering rules in the US would result in losing private offering exemption and being required to, among other things, register the fund interests with SEC, strict compliance with the private offering rule under the Measures has broader significance in China because this could help GPs/fund managers and their employees avoid potential criminal liabilities for allegedly engaging in illegal fund-raising activities. Due care must therefore be taken during the offering process to ensure full compliance.

Towards uniformity

The Measures have unveiled a new trend towards a uniform regulatory regime for the private fund industry in China, although they are still haunted by the shadows of the CSRC wrestling with other agencies for the power to regulate this industry. As an initial effort towards that goal, it has left unresolved many issues that a typical private fund will face, such as the double-taxation problem. In particular, the Measures have not addressed the treatment of offshore funds and offshore GPs/fund managers under the new regime. It is therefore vital to remain up to date on the latest legislative developments, and, hopefully, these issues will be addressed in the Regulations, which will be the next big thing to come.

David Li, AllBright Law Offices, Shanghai

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